Government spending and its effect on the economy is a perpetual source of debate. This column argues that too much discussion has focused on government purchases, when the fiscal expansion from 2007 to 2009 was all about transfers. It suggests that fiscal spending on transfers can boost the economy in a recession, though only if the transfer moves resources between the right groups.

Between 2007 and 2009, government expenditures increased rapidly across the OECD countries. In the US, the ratio of government expenditure to GDP increased by 4.4%, the largest two-year increase in the last 50 years.

While much has been learned, there is a discomforting disconnect between this research and the recent fiscal expansion. Almost all of the work so far has focused on government purchases. But, in the data, the increase has been in government expenditures.

National accounting determines that expenditures equal purchases plus interest payments plus transfers. A well-known fact is that almost all of the trend increase in expenditures in the post-war US was due to transfers. But what about in the last two years? Between the last quarters of 2007 to 2009, 75% of the increase in expenditures was due to an increase in transfers. Therefore, while all the research has been focusing on purchases, that is not where the money is. Transfers are the key.

Is the US special?

Table 1 decomposes the increase in total spending across many OECD countries into transfers and purchases (interest payments are very small). The second column shows that 2007-09 was a period of large fiscal expansion in almost all countries. The second and third columns show that, in the majority of countries, transfers accounted for more than half of this increase. The fourth column subtracts the average increase in spending in the 8 years before 2007 and the rate of nominal GDP growth from the growth in transfers. This provides a measure of the growth in transfers above and beyond what was usual in the recent past. By this measure, in almost all countries, transfers increased at an extraordinary rate, relative to growth and recent trends. The US is among the largest. The increase in government spending from 2007 to 2009 was extraordinary, but perhaps even more extraordinary is what drove it, i.e. transfers.

Table 1. Government expenditures and components from 2007Q4 to 2009Q4

Country

Percentage change in total expenditures

Fraction of increase in expenditures due to transfers

Fraction of increase in expenditures due to purchases

Transfers growth beyond trend and GDP growth

US

14.2%

75%

27%

25.4%

Ireland

2.5%

232%

-206%

37.9%

Italy

1.0%

147%

32%

6.9%

Luxembourg

4.3%

145%

-60%

12.6%

Portugal

7.4%

101%

4%

12.7%

Japan

5.3%

86%

9%

-9.3%

Sweden

6.5%

69%

52%

19.9%

Greece

17.2%

75%

22%

24.3%

France

6.0%

74%

46%

9.5%

Slovakia

20.7%

64%

34%

37.5%

Netherlands

15.9%

63%

41%

23.8%

Belgium

13.3%

60%

42%

15.4%

Germany

9.2%

59%

44%

11.2%

UK

17.3%

52%

47%

24.4%

Spain

11.1%

47%

50%

17.1%

Finland

11%

43%

56%

25.7%

Poland

30.2%

40%

52%

21.9%

Denmark

14.2%

36%

56%

19.8%

Austria

5.4%

35%

65%

6.8%

Czech Republic

10.3%

34%

62%

3.7%

Canada

11.2%

31%

76%

4.2%

Hungary

-4.3%

78%

44%

-9.9%

Notes: The fractions due to purchases and transfers do not add up to 100 because interest payments are omitted. See Oh and Reis (2011) for the sources.

What is behind the rise in US transfer spending?

Looking at the detailed government spending accounts for the US, Table 2 breaks down the increase in spending into several sub-categories. Noticeably, all four categories in transfer spending, healthcare, retirement, unemployment insurance and others, increased by roughly $100 billion each. Adding the numbers in the table, the increase in spending on retirement, disabilities and healthcare between 2007 and 2009 was as large as the increase in government purchases. You may not have guessed it from the debate about the fiscal expansion, but while government purchases and unemployment insurance occupy almost all of the attention, there was as much of an increase in spending in retirement, healthcare and other transfers.

Table 2. Dollar increase in US government expenditures, 2007 to 2009

Dollar change in billions

Change in percentage of GDP

Social transfers

409

2.72%

Retirement and disabilities

98

0.63%

Medical

121

0.78%

Unemployment insurance

97

0.68%

Income assistance and others

94

0.63%

Capital transfers

131

0.91%

Total transfers

522

3.50%

Government purchases

219

1.33%

Government expenditures

710

4.57%

Notes: Purchases plus transfers do not equal expenditures because interest payments are omitted. Total transfers do not equal capital plus social transfers in part because subsidies are omitted. See Oh and Reis (2011) for sources.

What is behind these increases? For retirement and disabilities, about two-thirds of the increase in spending can be attributed to an increase in the share of the population that is out of the labour force or is above 65 years. The US population is ageing and 2008 and 2009 were two years when quite a few baby boomers retired.

More than half the increase in medical spending is due to increases in medical prices. Between 2007 and 2009, the Consumer Price Index (CPI) for medical care increased by 7%, while the non-medical component of headline CPI rose by only 3.2%. This is not unusual. Over the last 20 years, breaking down the increase in medical spending into price and quantity, these two components get roughly the same weight.

After taking into account the aging population and the rising price of healthcare, much remains to be explained. Some of the increase in transfers may perhaps have been driven by discretionary increase in the generosity of existing social programmes, but more research is needed.

Which is more effective: Transfers or purchases?

In old-fashioned Keynesian models, the multiplier effect on government transfers is lower than that on purchases. That is, purchases raise output by more than transfers and so are more effective at fighting recessions.

In typical neoclassical models, the transfers’ multiplier is zero. These models have a representative agent, which means that transferring resources across people has no impact for macroeconomic aggregates. As for the purchases multiplier, its value depends on other features of the model, and estimates can be as low as zero or as high as three, that is $1 of purchases can raise total output by as much as $3 (Woodford, 2011). Crucially, since transfers do not use any resources, while each $1 of government purchases implies $1 less of private purchases, the right comparison is between the transfers’ multiplier and the net purchases’ multiplier, which equals the gross multiplier minus 1.

In recent work (Oh and Reis 2011), we propose a simple model in which transfers between agents matter because financial markets are incomplete, and in which aggregate demand matters because there are nominal rigidities. The model nests both the standard neoclassical and new Keynesian models as special cases.

In our model, the transfers’ multiplier is positive due to two channels. The first is a neoclassical channel, whereby those workers who bear the burden of funding the transfers respond by increasing their labour supply, thus boosting employment and output. The second is a Keynesian channel, whereby transferring resources from households with low marginal propensity to consume to those with a high one boosts aggregate demand and so raises output.

We find that the transfers’ multiplier is below the gross multiplier for purchases, but well above the net purchases’ multiplier. From the perspective of this model, fiscal spending on transfers can boost the economy in a recession. But, crucially, this is only the case if the transfer is well-targeted, moving resources between just the right groups of people in the economy.